September 17, 2006

Systemic Risk and Central Banker Humor

RGE - Geithner on hedge funds: Geithner's speech is long, and I'm not going to to précis it. But I'll leave you for the weekend with a bit of very, very dry central-banker humor:

If individual dealers to a very large hedge fund each operate with adequate knowledge of the risk profile of the fund, if they each make conservative judgments about their potential direct exposure to the fund in a stress scenario, if they limit the overall exposure of the firm as a whole to the broader market distress that might accompany that failure of a major hedge fund, if they compensate for the uncertainty in making these judgments by charging appropriate risk premia or building in a greater cushion against adversity, and if the supervisory constraints on the core institutions adequately offset the moral hazard that comes with that relationship, then the financial system as a whole will be less vulnerable to distress in the hedge fund sector.

That's humor as in "Dr Strangelove", of course. Geithner knows, and Geithner knows that we know, that none of these things is plausible, let alone likely. Geithner runs the institution which had to coordinate the bailout of LTCM, and I read this speech as Geithner saying that although certain risk-management systems might have improved since LTCM collapsed, there's still as much systemic risk from the hedge-fund industry now as there ever was – if not substantially more. What's more, a tweak to margin requirements won't change that. Reading between the lines, Geithner seems to be saying that if margin requirements went up, the main effect would be that banks' Tier 1 capital would just go down to compensate. In financial-sector regulation, there are no easy answers any more.

Comments

RGE - Geithner on hedge funds: Geithner's speech is long, and I'm not going to to précis it. But I'll leave you for the weekend with a bit of very, very dry central-banker humor:

If individual dealers to a very large hedge fund each operate with adequate knowledge of the risk profile of the fund, if they each make conservative judgments about their potential direct exposure to the fund in a stress scenario, if they limit the overall exposure of the firm as a whole to the broader market distress that might accompany that failure of a major hedge fund, if they compensate for the uncertainty in making these judgments by charging appropriate risk premia or building in a greater cushion against adversity, and if the supervisory constraints on the core institutions adequately offset the moral hazard that comes with that relationship, then the financial system as a whole will be less vulnerable to distress in the hedge fund sector.

That's humor as in "Dr Strangelove", of course. Geithner knows, and Geithner knows that we know, that none of these things is plausible, let alone likely. Geithner runs the institution which had to coordinate the bailout of LTCM, and I read this speech as Geithner saying that although certain risk-management systems might have improved since LTCM collapsed, there's still as much systemic risk from the hedge-fund industry now as there ever was – if not substantially more. What's more, a tweak to margin requirements won't change that. Reading between the lines, Geithner seems to be saying that if margin requirements went up, the main effect would be that banks' Tier 1 capital would just go down to compensate. In financial-sector regulation, there are no easy answers any more.